A More Complete Picture of DB Plan Liabilites

May 30, 2014 (PLANSPONSOR.com) – Measures of defined benefit (DB) plan liabilities currently used by plan sponsors do not tell the whole story, contends a paper from Russell Investments.

Plan sponsors typically focus on the projected benefit obligation (PBO) liability metric, says Marcus Muetze, senior consultant at Russell Investments. He tells PLANSPONSOR the PBO, which appears on the corporate balance sheet, is used in calculating pension expense, so it’s a very important metric.

Plan sponsors also calculate liabilities used to determine minimum required contributions or Pension Benefit Guaranty Corporation (PBGC) variable rate premiums, but in the paper “Introducing TFBO,” Muetze says these metrics do not tell plan sponsors the whole story about their plan’s long-term economics.

Investment and funding policy decisions must be made with an eye not just to liabilities that have already accrued, but also to those that will accrue in the future, Muetze contends. In other words, an important metric is the total future benefit obligation (TFBO).

TFBO looks at the present value of all benefits that will ever be earned by current plan participants as well as by future participants (or new entrants). It is an estimate of all benefits that will ultimately need to be paid out of the plan’s assets. Muetze says it is the most effective liability measure to help plan sponsors set funding and investment policies.

“It’s not a better liability metric than any other,” Muetze admits, “but it’s a different metric—an additional tool to help plan sponsors understand the long-term economics of their plan and do it in a more full and complete way.” He describes the measure as a liability metric that gives a plan sponsor the full picture of funding obligations in the long term, so that the true long-term funding and investment challenges are clearer.

Sponsors of DB plans need to know how their liabilities are going to evolve over the long term. How big benefits will ultimately be is an important question. Muetze says the PBO tells only the story of benefits that have accrued until now—not all benefits that will need to be paid out in the future. Even though this cannot be predicted with perfect accuracy, he says, it should still be attempted.

“Actuaries make an estimate beyond PBO on a regular basis,” Muetze points out, and larger actuarial firms do it as part of the standard valuation process. The calculation is called the present value of future benefits (PVFB).

According to Muetze, this is an actuarial attempt to look into the future to see how much benefit will accrue over the entire future working life of the current participants. Actuaries do not always share this figure with a plan sponsor, he says, but if a plan sponsor wants to know, Russell requests the number, which is easy for them to provide, since it was already calculated.

The metric is helpful, Muetze says, because ultimately plan sponsors are not just going to have to pay out the PBO liability number. “Over the long term, they’ll have to pay out the whole liability number,” he says. The metric is a way to understand how a plan’s assets are doing versus this long-term liability. The information can help set a more effective, more informed investing policy immediately.

Using the PBO measure, three plans might have an identical 97% funding status, Muetze says, but looking at them through the lens of the TFBO metric, the picture could be very different because their future liabilities are so different. This naturally would have an impact on investing policy and contributions.

A plan should calculate future benefit accruals, which Muetze says are going to be significant. The plan needs to assess whether assets alone can make up that piece, or the plan sponsor should consider options, such as coming up with contributions and a more realistic funding and investing policy, perhaps one that is more realistic than contributing the minimum each year. If the plan’s policy allows it to fund the minimum requirement, this strategy might require a re-think depending on what future liabilities look like, Muetze says.

“Introducing TFBO: A Tool to Help You Understand the Long-Term Economics of Your Plan” can be downloaded from Russell Investments’ website.